Think of it as the Great Margin Squeeze. For the most recently completed quarter, corporate earnings are down but revenues are up. What gives?

To date for Q4 2020, the S&P 500 is posting a year-over-year decline in earnings per share (EPS) of -4.7%. However, Q4 revenues for the S&P 500 are showing a year-over-year growth rate of 0.7%. Clearly, net profit margins are under pressure and that could bode badly for future quarters. Below, I examine whether investors should be worried.

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According to research firm FactSet, eight sectors are reporting (or are projected to report) a year-over-year decline in their net profit margins in Q4 2020 compared to Q4 2019, led by industrials (6.2% vs. 8.6%) and communication services (10.3% vs. 12.3%). The energy sector is predicted to report a loss for the quarter, which means a net profit margin can’t be calculated for the sector.

Six sectors are reporting (or are projected to report) net profit margins for Q4 that are below their five-year averages, led by industrials (6.2% versus 8.4%) and utilities (10.4% versus 12.5%). The following chart breaks down year-over-year Q4 profit margins by sector:

Higher costs and falling demand are squeezing margins. A low profit margin indicates a low margin of safety and raises the risk that a decline in revenue will wipe out profits and result in a net loss, or a negative margin.

Trends indicate, however, that margins are about to improve along with a recovering economy. Accordingly, Wall Street remains bullish. On Monday, stocks largely recovered from a deep slump earlier in the day to close mostly higher. The Dow Jones Industrial Average slipped 36.62 points (-0.12%), in negative territory but well off its intra-day lows. The S&P 500 rose 13.87 points (+0.36%) and the tech-heavy NASDAQ climbed 92.93 points (+0.69%); both indices hit all-time highs. A bevy of mega-cap tech earnings reports are due this week and investors are optimistic.

Competing with that optimism, though, is concern that Republicans in Congress will stymie the Biden stimulus plan. In pre-market futures trading Tuesday, stocks were edging lower. Volatility is likely to increase during the early days of the Biden regime, as the White House grapples with a confrontational GOP.

Regardless, we’re getting signals that the virus-battered economy is healing. The Federal Reserve Bank of Chicago reported Monday that the U.S. economy gained strength in December compared with the previous month, driven by an acceleration of production-related indicators.

The closely watched Chicago Fed National Activity Index came in at 0.52 in December, up from 0.31 in November and pointing to an uptick in economic growth in the month. The figure exceeded the analyst consensus. Stocks had been trending sharply lower Monday, until the Chicago Fed report was released and helped the market pare its losses.

Earnings growth to the rescue…

Stocks have continued to rally in 2021, despite the economic and human damage wreaked by the coronavirus pandemic. But to justify further significant stock price appreciation in 2021, we’ll need to see a big improvement in corporate earnings. Luckily, it appears that we’ll get it.

For calendar year (CY) 2020, the consensus of analysts is for an earnings decline of -12.9%, according to FactSet. But for this year, the earnings picture gets better. For Q1 2021, analysts are projecting earnings growth of 16.8%. For CY 2021, analysts are projecting earnings growth of 22.5%.

However, despite improving corporate earnings growth, pandemic-related economic risks haven’t disappeared. Stocks are overvalued and they’re vulnerable to bad news on COVID-19. The recent emergence of deadlier strains of the virus should keep you on your toes, for the sake of your personal safety as well as your portfolio.

More than ever, you need to be selective with your investments. That’s why our investment team has put together a special report: “5 Red Hot Stocks to Own in 2021.” In this report, we provide the names and ticker symbols of the highest-quality stocks to own for the new year. Click here for your copy.

John Persinos is the editorial director of Investing Daily. You can reach John at: mailbag@investingdaily.com. To subscribe to his video channel, follow this link.